Beta is a measure of the volatility — or systematic risk — of a security or portfolio compared to the market as a whole i.e., how much a security moves with respect to the overall market movement. In statistical terms, beta represents the slope of the line through a regression of data points. In finance, each of these data points represents an individual stock's returns against those of the market as a whole. Beta is used in the capital asset pricing model (CAPM), which describes the relationship between systematic risk and expected return for assets (usually stocks).

 

A security's beta is calculated by dividing the product of the covariance of the security's returns and the market's returns by the variance of the market's returns over a specified period. 

 

                              Beta Coefficient = Covariance (Re, Rm)

                                                                            Variance (Rm)

where:

Re = Return of the Security

Rm = Return of Overall Market

 

The beta calculation is used to help investors understand whether a stock moves in the same direction as the rest of the market. It also provides insights about how volatile–or how risky–a stock is relative to the rest of the market. For beta to provide any useful insight, the market that is used as a benchmark should be related to the stock. 

 

Types of Beta Values

 

Beta Value Equal to 1.0 (β = 1)

 

If a stock has a beta of 1.0, it indicates that its price activity is strongly correlated with the market. A stock with a beta of 1.0 has systematic risk. However, the beta calculation can’t detect any unsystematic risk. Adding a stock to a portfolio with a beta of 1.0 doesn’t add any risk to the portfolio, but it also doesn’t increase the likelihood that the portfolio will provide an excess return.

 

Beta Value Less Than One (β < 1)

 

A beta value that is less than 1.0 means that the security is theoretically less volatile than the market. Including this stock in a portfolio makes it less risky than the same portfolio without the stock. For example, utility stocks often have low betas because they tend to move more slowly than market averages.

Beta Value Greater Than One (β > 1)

 

A beta that is greater than 1.0 indicates that the security's price is theoretically more volatile than the market. For example, if a stock's beta is 1.2, it is assumed to be 20% more volatile than the market. Technology stocks and small cap stocks tend to have higher betas than the market benchmark. This indicates that adding the stock to a portfolio will increase the portfolio’s risk, but may also increase its expected return.

 

Negative Beta Value (β < 0)

 

Some stocks have negative betas. A beta of -1.0 means that the stock is inversely correlated to the market benchmark. This stock could be thought of as an opposite, mirror image of the benchmark’s trends. Put options and inverse ETFs are designed to have negative betas. There are also a few industry groups, like gold miners, where a negative beta is also common.

Asset Beta or Beta of Private Equity Firm

 

Unlevered beta (a.k.a. Asset Beta) is the beta of a company without the impact of debt. It is also known as the volatility of returns for a company, without taking into account its financial leverage. It compares the risk of an unlevered company to the risk of the market. It is also commonly referred to as “asset beta” because the volatility of a company without any leverage is the result of only its assets.

 

Typically, unlevered Beta is used to compute Beta for private equity companies or for time-specific projects. 

 

Since, private equity firms aren’t traded on the stock exchanges, we cannot compute its beta due to lack of historical trading prices. In such cases, we consider companies that are comparable to that private equity company for its beta calculation. 

 

The process goes as follows

  1. Finding out the listed comparable companies of the private equity firm

  2. Compute the Beta of the comparable company 

  3. Un-lever the Beta by removing the debt aspect of the listed company. 

                    Unlevered Beta= Levered Beta of Comparable firm

                                                             (1+ Debt*(1-Tax Rate)

                                                                                    Equity)

 

    4.Now re-lever the beta by adding the debt aspect of the private equity to this unlevered Beta

 

                    Re-levered Beta= Unlevered Beta*(1+ Debt*(1-Tax Rate)

                                                                                                                   Equity

 

  1. We arrive at the Beta of the Private Equity firm

  2. This process is called “Pure Play Approach”